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3 Ways to Add Tax Diversification to Your Portfolio

Entire industries and marketplaces have been built on the importance of asset allocation and diversification within your investment portfolio. But you don't hear as much about an equally important form of diversification: tax diversification.

One of the biggest investment expenses you will face in retirement is taxes. Planning for taxes can impact your long-term return and increase your likelihood of reaching retirement and financial independence.

There are three baskets of holdings that are each taxed differently: after-tax holdings, tax-free holdings and tax-deferred holdings. Each type of investment has unique planning opportunities, and, if structured correctly, can allow you to control how much you pay in taxes each year in retirement.

Here are the three main ways your retirement assets are likely to be taxed, and how they work within your retirement plan:

After-tax holdings. These are your basic savings and investment accounts. The initial investments and contributions to these accounts have already been taxed. However, any income from dividends, interest or capital gains generated within these accounts will be taxed in the year the income is received. These types of accounts provide the following:

-- Liquidity. This is where you want to save funds you will need access to for emergency reserves or current and short-term cash flow.

-- Specific tax-favored investments. Investments that generate qualified dividends and realized long-term capital gains (which typically means holding the investment greater than 12 months) often have lower tax rates than ordinary income. You can capitalize on the lower tax rates by keeping these investments in a taxable account.

Tax-free holdings. These are the investments that allow you to avoid future taxes on the investment. Assets held in Roth accounts and municipal bonds are the primary tax-free investments most people will hold.

Roth accounts contain assets that have already been taxed, and no tax deduction is received when you contribute to these accounts. However, Roth assets are powerful for investors because they are allowed to grow tax-free. This means that all the compound interest grows without current and future taxation. Roth accounts can be especially beneficial for young investors who are in lower tax brackets because they have decades for the tax-free investment growth to compound.

Imagine the power of funding a Roth IRA with $5,500 at age 25 and then allowing it to grow for 30 years. Assuming that the account earns 8 percent annual returns over that period of time, the value of the initial investment would grow to over $60,000. The $54,500 gain would be completely tax-free.

Roth accounts are a great place to allocate your growth investments, because you won't have to pay tax on the investment earnings. Roth accounts come in two forms:

-- Employer provided Roth accounts. Workplace Roth accounts include Roth 401(k)s, 403(b)s and 457 plans and have the same savings limits as traditional retirement plans. Those under age 50 can contribute up to $18,000 per year. The limit increases to $24,000 per year for those who are 50 or older and maximize the $6,000 catch-up contribution in 2015. A benefit of Roth retirement accounts is that your ability to save in the plan isn't phased out if you have a high income, the way it is with Roth IRAs. However, if you are in a higher tax bracket, you need to compare the benefit of tax-free growth to taking a current deduction by contributing to a traditional retirement account.

-- Roth IRAs.Roth IRAs are not subject to required minimum distributions at age 70 ½. This makes Roth investments a great planning tool for seniors who are retired and planning on leaving assets to heirs. You can contribute $5,500 per year to Roth IRAs, and if you are over 50 that number increases to $6,500 due to the $1,000 annual catch-up contribution. Keep in mind that your ability to make contributions phases out when your adjusted gross income is between $183,000 and $193,000 for married couples and $116,000 to $131,000 for individuals in 2015.

Another tax-free investment you might hold is municipal bonds. Muni bonds are debt that local governments issue to fund projects. The federal government exempts these holdings from federal taxation. If a muni bond investor also resides in the same state where the bonds were issued, then the investment is also exempt from state income taxes.

Tax-deferred holdings. Contributions made to your workplace retirement account, including 401(k)s, 403(b)s, 457s and the Thrift Savings Plan, fall into this category, unless you specifically allocate your contributions to a Roth account. You typically receive a tax deduction for contributions to the account, and the earnings within these accounts are tax deferred. But once you start to take withdrawals, the distributions are taxed as ordinary income. Therefore, it is beneficial to allocate investments that are taxed at regular income tax rates to this account, such as your bond and fixed income holdings. There is a tremendous benefit to allowing assets that are taxed at a high rate to grow and compound without having to pay annual taxes on the income.

Portfolio design can be like building a large jigsaw puzzle. You want to make sure the pieces of your portfolio fit together just right so you can maximize your growth and minimize taxes and fees. It takes a bit of extra work to understand the benefits of tax diversification, but the impact on your long-term goals can be substantial.

Brian Preston and Bo Hanson are fee-only financial planners who host the podcast, "The Money-Guy Show".